Trading by Market Cycle

By: Chris Vermeulen

"The markets can remain irrational longer than you can stay solvent,” a quote often attributed to John Maynard Keynes, puts great emphasis on the importance of discipline, risk management, and a keen eye for price action, writes Chris Vermeulen of TheGoldAndOilGuy.com.

I know most Apple (AAPL) enthusiasts will be rolling their eyes at this analysis, and that’s fine because the rest of us need people to buy our shares as we unload long positions or sell Apple short. All joking aside, the charts below clearly show some very interesting information you cannot afford to overlook. At minimum, take a quick glance at these charts, which tell the full story on their own.

The Four Stages of Apple and Research in MotionMarkets are cyclical in nature. There is a constant process of expansion and contraction, rally and decline that continues as the market determines the theoretical fair value of a security. The sum of these moves forms an unquestionable cyclical pattern consistent within all time frames.

During a cycle a stock enters different phases of support, from irrational exuberance typically found before its peak, to periods of widespread discontent where its price is continually punished. However there are never distinctly good or bad stocks.

Every “good” stock will eventually become a bad one and vice versa. There are, however, good trades; trades that reward an investor who has correctly anticipated a move and positioned himself accordingly.

It is important to note that this works with commodities like gold and silver, which are trading at a very interesting point in their life cycle. Looking at various time frames in SPDR Gold Trust ETF (GLD) and iShares Silver Trust ETF (SLV), you can see this.

Classic economic theory dissects the economic cycle into four distinct stages: expansion, trough, decline, and recovery. A stock is no different, and proceeds through the following cycle:

Stage 1: After a period of decline, a stock consolidates at a contracted price range as buyers step into the market and fight for control over the exhausted sellers. Price action is neutral as sellers exit their positions and buyers begin to accumulate the stock.

Stage 2: Upon gaining control of price movement, buyers overwhelm sellers and a stock enters a period of higher highs and higher lows. A bull market begins and the path of least resistance is higher. Traders should aggressively trade the long side, taking advantage of any pullback or dips in the stock’s price.

Stage 3: After a prolonged increase in share price, the buyers now become exhausted and the sellers again move in. This period of consolidation and distribution produces neutral price action and precedes a decline in the stock’s price.

Stage 4: When the lows of Stage 3 are breached, a stock enters a decline as sellers overwhelm buyers. A pattern of lower highs and lower lows emerges as a stock enters into a bear market. A well-positioned trader would be aggressively trading the short side and taking advantage of the often quick declines in the stock’s price. More times than not, all of Stage 2 gains are given back in a short period of time.